August 7, 2008

Financial intermediaries

With advances in computer technology, one can transfer money instantly, anywhere in the word, you can trade your funds across major stock exchanges online, you can use your credit card across the globe and so on. Lending and borrowing of money is made simple by financial institutions called financial intermediaries. Financial intermediaries such commercial banks, credit unions and brokerage funds carryout these transactions on your behalf. A financial intermediary is a financial institution that borrows from savers and lend to individuals or firms that need resources for investment. The investments made by financial intermediaries can be in loan and/or securities. Basic role of financial intermediaries is transforming financial assets that are less desirable for a large part of the public into other financial asset, which is preferred more by the public. This transformation involves at least four economical functions: providing maturity intermediation, risk reduction via diversifications, reducing the costs of contracting and information processing and providing a payment mechanism.

Without financial intermediation we must not have seen revolution in financial services in past couple of decades. Financial intermediation is responsible for creation of institutional investors in financial market. Modern world would not have been so modern without financial intermediaries. Financial intermediation has won savers confidence by protecting their asset while providing efficient services to help manage their asset. On contrary, with pool of household savings from savers, they emerged as one large lender who can lend money to businesses and various other borrowers. Financial intermediaries are vital part of our economic system and they help to maintain constant flow of money in economy.

If there were no intermediaries, individual savers would have to directly purchase the securities of borrowers. There would have been incompatibility of the maturity needs of lenders and borrowers since most savers want to lend funds at short maturity, while borrowers want to borrow at longer maturities. It would have been difficult to match small amounts of individual savings to the larger loan amounts desired by borrowers. This would have cause borrowing more difficult and more tedious. Financial intermediaries perform important function of maturity intermediation to make investment from savers and money borrowing for borrowers seamless. Maturity intermediation involves a financial intermediary issuing liabilities against it that have maturity different from the assets it acquires with the fund raised. An example is a commercial bank that issues certificate of deposit and invests in assets with a longer maturity than those liabilities. Maturity intermediation offers more choice concerning maturity for their investments to investors and reduces cost of long term borrowing for borrowers. Financial intermediaries issue their own debt claims to the saver in forms more attractive to savers, and in turn, lend to borrowers on terms satisfactory to the borrowers.

Financial intermediaries bears risk on behalf of investors by investigating their savings across various sectors of business. They transform risk-by-risk spreading and risk pooling; they can spread risk across a range of institution. In turn institutions can pool risk by spreading investment across firms and various projects. Diversification allows a financial intermediary to allocate assets and bear risk more efficiently. Financial intermediaries do risk screening, risk monitoring and risk evaluation; it is more efficient for institution to screen investment opportunity on behalf of individuals than for all individuals to screen the risk. It helps individual saver to save time and money and offers low risk investment opportunity. One of the common example of this function is; a dollar deposited in a checking or savings account, it is not redeemed at less than a dollar but in turn one get paid interest on it over period of time. Therefore without financial intermediaries it would really have been difficult for individual investor to screen prospect borrower or investment opportunity, which would have discouraged individual savers from lending money and would have affected economical developments.

Financial intermediaries provide convenient and safe way to store finds and creates standardized forms of securities. It also facilitates easy exchange of funds. Due to high volume it is able to bear transaction and information search cost on behave of savers. Therefore, individual saver enjoys financial services that enable them to deposit and withdraw funds without negotiation whereas borrower avoids having to deal with individual investors. Since it has information available for both lenders and borrowers, it minimizes information cost for analyzing their data. Without financial intermediaries lenders and borrowers would have to pay higher transactional and information costs.

Modern world would not have been so efficient, aggresive and progressive without financial intermediation.

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